Executive Summary
Based on much reading and research, we could end up with a scenario where the markets do well (in general, and not without pullbacks) for the next 18-24 months. Signs of economic growth, however, are being greeted with even more skepticism. Despite measures of positive change at the margin in manufacturing and services indices (ISM), shipping indices (Baltic Dry Index), credit spreads (corporate rates vs. US Treasury rates), retail sales and even employment, many forecasters are still singing the blues about the economy and seem stuck in last years' news with talk about further mortgage defaults continuing to pound the banks, or the sluggish consumer "saving" instead of "consuming." It is our belief that the problem which seems obvious is rarely the one that causes the most trouble, and the one to be most wary about usually lurks underneath the surface. While there certainly are some underlying negative scenarios, which we will outline, the positive developments that are beginning to evolve should offset if not overwhelm the negatives in the mid-term.
The More Things Change the More They Stay the Same
The forces that have damaged the world’s markets and global economy have been indiscriminate, taking down good companies along with the bad. During periods when fundamentals no longer “seem” to apply, they still do. The scale and magnitude of the decline, while painful, also represents long-term investment opportunity. The valuations of many companies appear relatively attractive. The causes of most market declines may all be different, but they also have many similarities. In most cases, the advances that preceded the declines wee the result of delirious optimism and excessive speculation that led to overblown valuations. The damage from this fallout can be widespread, hurting quality companies along with the suspect. Periods such as these are often accompanied by irrational pessimism, risk aversion and unrealistically low valuations. This is the one thing in common that we care about—the price we pay for a company’s earnings is much lower than it would otherwise be.
Inflation Primer: A Monetary Phenomenon
People have been hoarding money, the savings rate is rising, the government is printing money, etc. When a recovery is on the horizon, this is when all the pent-up new supply of hoarded dollars becomes the phenomenon of “too many dollars chasing too few goods”. Voila. Inflation.
Milton Friedman said it best: “Inflation is always and everywhere a monetary phenomenon”. His simple equation, MV=PQ explains the relationship between the Money Supply, Velocity of Money, the Price Level, and Quantity of the real value of aggregate transactions in the economy. Over the years dissertation after dissertation has attempted to destroy this formula, and failed. The relationship between M and P has indeed only been bolstered over the years. To solve for Price Level (P), we just re-arrange it to MV/Q=P.
Simply put, the Money Supply, M, has increased more dramatically over the last year (Presidents Bush and Obama) than in the past 50 years, by a factor of 10. It has actually doubled over the last year, but as they say in the Wizard of Oz, “disregard the man behind the curtain [Fed/Treasury]”. The Velocity of money has slowed down due to the “recession” and a higher savings rate, let’s use a 25% slowdown. The eventual Price level is what we are solving for, and the Quantity of aggregate transactions has decreased due to recession, higher savings rates, discounts in the economy, etc (let’s say down 4%).
M (2.0) x V(.75)/Q (.96) = P
In this case, P= 1.56%, which means inflation would be 56%.
Now let’s assume everything the same, except we’ll change the aggregate level of value of transactions in the economy, Q. Let’s assume we end up coming out of the recession with a 4% growth rate, which would be characterized as “incredibly optimistic” under normal circumstances.
M (2.0) x V (.75)/Q(1.04) = P
In this case, P= 1.44%, meaning inflation would be 44%.
This illustration shows the relationship in all of its simplicity. A noteworthy aspect of the formula is that the resulting implied inflation rate jives with common sense; any layman can understand that doubling the number of available dollars could debase the currency by approximately half its purchasing power. The Fed has recently assured us that they will “withdraw policy accommodation in a smooth and timely manner”, meaning the Fed will do everything in its power to control inflation by reducing the money supply as needed to stave off inflation. It must be noted that inflation by itself is not a foregone conclusion, as the Fed actually “could” succeed, which would of course result in dampened economic growth. What the calculation above does not tell us is whether the U.S. could end up with fairly controlled inflation but with a debased currency.
Re-flation of Assets
The economic debate has centered on deflation versus inflation. Particularly in Q1 much data pointed to deflation as a hangover effect from the Fall 2008, when business activity fell off a cliff. In Q2 we started to see a bounce in stocks, and for the last two months we have had “mixed” data, which was much better than “terrible” data. Based upon a fiat currency (our currency has been this way since we went off the gold standard), inflation is always preferable to deflation. Deflationary risks are to be avoided if at all possible, and by that measure we are likely to avoid it on a grand scale. In the meantime, and until inflation surfaces, we may be in an asset-inflation “window”, whereby all assets “re-flate” for a while. And yet, economic data and earnings need to come through in order for this to continue. We note that the volatility level in the market has waned, that investors are buying stocks, selling long term bonds, and generally taking more risk.
The Five Year Post-Peak Scenario
On a historical basis, we have come to learn that every major stock market peak of the 20th Century was followed by a crash in the U.S. dollar five years later. People who kept their savings in dollars saw the purchasing power of their savings shrink substantially (so don’t keep it in your mattress). For example, four years after the peak of 1929, FDR closed the banks and made it illegal for private citizens to own gold. In January 1934—five years after the bubble—he devalued the dollar, crushing people’s savings. Commodity prices had triple-digit rises in the mid-1930s and speculators once again made a fortune. The same thing happened five years after the market peaked in the late 1960s. Five years later, Nixon took the dollar off the gold standard (this time for good). Commodity prices soared for the next ten years, with the price of gold reaching $850/oz by the time it was over. Fast forward—the stock market popped in March 2000, and five years later in the Spring of 2005, the bull market in commodities was on. Oil went from $40 to $140; gold went from $400 to $1000/oz. We just had another peak in the stock market in October 2007. Based upon this precedent, we could expect a raging bull market in commodities (due to a falling US dollar value, big inflation, or both) somewhere between mid-2011 and the fall of 2012. This is the risk, and this is the opportunity.
Based on the sheer massiveness of the explosion of the money supply, we tend to believe that a scenario like this, if it does transpire, may be more likely in the 2011 time frame. However, until inflation really heats up, we expect a continued rebound in stocks (re-flation of assets), which is consistent with the data, our perception of the market’s psychology, and counter to the pessimism that a rally cannot occur. Since the Panic of 2008 has subsided substantially, investors are fleeing cash, and one of the first things they’re likely to buy is stocks. History suggests we may see new all-time highs in about two years, followed by the a potential visit from the inflation bogeyman. In a reflationary period it is quite possible for all types of assets to go up in value, and then based upon this 2011/2012 time frame, commodities and stocks could decouple in favor of commodities and commodity-related enterprises.
Positioning Globally for Any Environment
The sectors we like most are commodity-related equities, including oil, coal, mining, agriculture, metals; we also like select healthcare, medical device, and biotech companies as well as a few select technology names that exhibit reasonable valuations (Growth At a Reasonable Price, GARP). The reasoning for our commodities-related/oil/metals bent is many-fold: 1) they are needed , (2) they appear undervalued and are economically sensitive; if they drop due to a double-dip recession it shouldn’t be disastrous due to their inherent value, and if the market goes up, they go up too, (3) commodities are priced in US$, so if the dollar goes down, it takes more US$ to buy them, meaning the producers of these commodities will have higher earnings, (4) during inflationary periods they tend to hold up the best, (5) if we experience a currency devaluation for whatever reason (and inflation is but another means of achieving this), see #1-4. So we are adding positions that can withstand gale force winds based on macroeconomics and/or deliver strong earnings.
If You have an ARM, Take Advantage of Fixed Rate Mortgages
What else is important during an inflationary run? How about the interest rate on your mortgage? If you have not done so, take advantage of still-historically low 30 year fixed mortgage rates. Earlier this year the 30 year dipped to about a 60-year low. It’s still cheap money, and it should be considered a “gift” from the Fed. The Fed has been busy monetizing debt. What do we mean by this? Well, the Fed has been taking money into the system by issuing U.S. Treasury securities, and then they’ve been buying up long Treasury securities and specific mortgage backed securities on the market. All the while they’ve been “telegraphing” this to the world. So maybe, just maybe, China, Japan, India, and Russia are selling into this buying? In all likelihood, this is so, therefore this policy works for a while and then treads water at best. By targeting certain bond yields, they’ve artificially created a low-rate environment, all by essentially using one credit card to pay down another. This is simply unsustainable and will desist at some unknown point in the future (probably when the data starts to look better). Take advantage of this, especially if you currently hold an adjustable rate mortgage.
Here’s the math behind why a fixed rate mortgage is better than an adjustable in a period of different rates of rising inflation:
Based on much reading and research, we could end up with a scenario where the markets do well (in general, and not without pullbacks) for the next 18-24 months. Signs of economic growth, however, are being greeted with even more skepticism. Despite measures of positive change at the margin in manufacturing and services indices (ISM), shipping indices (Baltic Dry Index), credit spreads (corporate rates vs. US Treasury rates), retail sales and even employment, many forecasters are still singing the blues about the economy and seem stuck in last years' news with talk about further mortgage defaults continuing to pound the banks, or the sluggish consumer "saving" instead of "consuming." It is our belief that the problem which seems obvious is rarely the one that causes the most trouble, and the one to be most wary about usually lurks underneath the surface. While there certainly are some underlying negative scenarios, which we will outline, the positive developments that are beginning to evolve should offset if not overwhelm the negatives in the mid-term.
The More Things Change the More They Stay the Same
The forces that have damaged the world’s markets and global economy have been indiscriminate, taking down good companies along with the bad. During periods when fundamentals no longer “seem” to apply, they still do. The scale and magnitude of the decline, while painful, also represents long-term investment opportunity. The valuations of many companies appear relatively attractive. The causes of most market declines may all be different, but they also have many similarities. In most cases, the advances that preceded the declines wee the result of delirious optimism and excessive speculation that led to overblown valuations. The damage from this fallout can be widespread, hurting quality companies along with the suspect. Periods such as these are often accompanied by irrational pessimism, risk aversion and unrealistically low valuations. This is the one thing in common that we care about—the price we pay for a company’s earnings is much lower than it would otherwise be.
Inflation Primer: A Monetary Phenomenon
People have been hoarding money, the savings rate is rising, the government is printing money, etc. When a recovery is on the horizon, this is when all the pent-up new supply of hoarded dollars becomes the phenomenon of “too many dollars chasing too few goods”. Voila. Inflation.
Milton Friedman said it best: “Inflation is always and everywhere a monetary phenomenon”. His simple equation, MV=PQ explains the relationship between the Money Supply, Velocity of Money, the Price Level, and Quantity of the real value of aggregate transactions in the economy. Over the years dissertation after dissertation has attempted to destroy this formula, and failed. The relationship between M and P has indeed only been bolstered over the years. To solve for Price Level (P), we just re-arrange it to MV/Q=P.
Simply put, the Money Supply, M, has increased more dramatically over the last year (Presidents Bush and Obama) than in the past 50 years, by a factor of 10. It has actually doubled over the last year, but as they say in the Wizard of Oz, “disregard the man behind the curtain [Fed/Treasury]”. The Velocity of money has slowed down due to the “recession” and a higher savings rate, let’s use a 25% slowdown. The eventual Price level is what we are solving for, and the Quantity of aggregate transactions has decreased due to recession, higher savings rates, discounts in the economy, etc (let’s say down 4%).
M (2.0) x V(.75)/Q (.96) = P
In this case, P= 1.56%, which means inflation would be 56%.
Now let’s assume everything the same, except we’ll change the aggregate level of value of transactions in the economy, Q. Let’s assume we end up coming out of the recession with a 4% growth rate, which would be characterized as “incredibly optimistic” under normal circumstances.
M (2.0) x V (.75)/Q(1.04) = P
In this case, P= 1.44%, meaning inflation would be 44%.
This illustration shows the relationship in all of its simplicity. A noteworthy aspect of the formula is that the resulting implied inflation rate jives with common sense; any layman can understand that doubling the number of available dollars could debase the currency by approximately half its purchasing power. The Fed has recently assured us that they will “withdraw policy accommodation in a smooth and timely manner”, meaning the Fed will do everything in its power to control inflation by reducing the money supply as needed to stave off inflation. It must be noted that inflation by itself is not a foregone conclusion, as the Fed actually “could” succeed, which would of course result in dampened economic growth. What the calculation above does not tell us is whether the U.S. could end up with fairly controlled inflation but with a debased currency.
Re-flation of Assets
The economic debate has centered on deflation versus inflation. Particularly in Q1 much data pointed to deflation as a hangover effect from the Fall 2008, when business activity fell off a cliff. In Q2 we started to see a bounce in stocks, and for the last two months we have had “mixed” data, which was much better than “terrible” data. Based upon a fiat currency (our currency has been this way since we went off the gold standard), inflation is always preferable to deflation. Deflationary risks are to be avoided if at all possible, and by that measure we are likely to avoid it on a grand scale. In the meantime, and until inflation surfaces, we may be in an asset-inflation “window”, whereby all assets “re-flate” for a while. And yet, economic data and earnings need to come through in order for this to continue. We note that the volatility level in the market has waned, that investors are buying stocks, selling long term bonds, and generally taking more risk.
The Five Year Post-Peak Scenario
On a historical basis, we have come to learn that every major stock market peak of the 20th Century was followed by a crash in the U.S. dollar five years later. People who kept their savings in dollars saw the purchasing power of their savings shrink substantially (so don’t keep it in your mattress). For example, four years after the peak of 1929, FDR closed the banks and made it illegal for private citizens to own gold. In January 1934—five years after the bubble—he devalued the dollar, crushing people’s savings. Commodity prices had triple-digit rises in the mid-1930s and speculators once again made a fortune. The same thing happened five years after the market peaked in the late 1960s. Five years later, Nixon took the dollar off the gold standard (this time for good). Commodity prices soared for the next ten years, with the price of gold reaching $850/oz by the time it was over. Fast forward—the stock market popped in March 2000, and five years later in the Spring of 2005, the bull market in commodities was on. Oil went from $40 to $140; gold went from $400 to $1000/oz. We just had another peak in the stock market in October 2007. Based upon this precedent, we could expect a raging bull market in commodities (due to a falling US dollar value, big inflation, or both) somewhere between mid-2011 and the fall of 2012. This is the risk, and this is the opportunity.
Based on the sheer massiveness of the explosion of the money supply, we tend to believe that a scenario like this, if it does transpire, may be more likely in the 2011 time frame. However, until inflation really heats up, we expect a continued rebound in stocks (re-flation of assets), which is consistent with the data, our perception of the market’s psychology, and counter to the pessimism that a rally cannot occur. Since the Panic of 2008 has subsided substantially, investors are fleeing cash, and one of the first things they’re likely to buy is stocks. History suggests we may see new all-time highs in about two years, followed by the a potential visit from the inflation bogeyman. In a reflationary period it is quite possible for all types of assets to go up in value, and then based upon this 2011/2012 time frame, commodities and stocks could decouple in favor of commodities and commodity-related enterprises.
Positioning Globally for Any Environment
The sectors we like most are commodity-related equities, including oil, coal, mining, agriculture, metals; we also like select healthcare, medical device, and biotech companies as well as a few select technology names that exhibit reasonable valuations (Growth At a Reasonable Price, GARP). The reasoning for our commodities-related/oil/metals bent is many-fold: 1) they are needed , (2) they appear undervalued and are economically sensitive; if they drop due to a double-dip recession it shouldn’t be disastrous due to their inherent value, and if the market goes up, they go up too, (3) commodities are priced in US$, so if the dollar goes down, it takes more US$ to buy them, meaning the producers of these commodities will have higher earnings, (4) during inflationary periods they tend to hold up the best, (5) if we experience a currency devaluation for whatever reason (and inflation is but another means of achieving this), see #1-4. So we are adding positions that can withstand gale force winds based on macroeconomics and/or deliver strong earnings.
If You have an ARM, Take Advantage of Fixed Rate Mortgages
What else is important during an inflationary run? How about the interest rate on your mortgage? If you have not done so, take advantage of still-historically low 30 year fixed mortgage rates. Earlier this year the 30 year dipped to about a 60-year low. It’s still cheap money, and it should be considered a “gift” from the Fed. The Fed has been busy monetizing debt. What do we mean by this? Well, the Fed has been taking money into the system by issuing U.S. Treasury securities, and then they’ve been buying up long Treasury securities and specific mortgage backed securities on the market. All the while they’ve been “telegraphing” this to the world. So maybe, just maybe, China, Japan, India, and Russia are selling into this buying? In all likelihood, this is so, therefore this policy works for a while and then treads water at best. By targeting certain bond yields, they’ve artificially created a low-rate environment, all by essentially using one credit card to pay down another. This is simply unsustainable and will desist at some unknown point in the future (probably when the data starts to look better). Take advantage of this, especially if you currently hold an adjustable rate mortgage.
Here’s the math behind why a fixed rate mortgage is better than an adjustable in a period of different rates of rising inflation:
This illustration is not perfect, since investor tax rates will vary in terms of tax savings, though the difference between a fixed and variable mortgage shows the relationship well. In a zero-inflation environment, the ARM will hold up fine, and actually is less expensive in terms of the “real” cost of the funds. As inflation ticks up, and as the ARMs adjust upward (again, imperfect since many are capped at a certain level) we can see that the “real rate” differential starts to become costly (not in terms of the ARM’s real rate, but as compared to the real rate available on a fixed rate mortgage—this is the opportunity cost). In the 10% inflation environment normally an ARM is capped at some point, maybe 5 points over the original ARM rate, so it completely depends what the original rate was. For many people who overextended and who only qualified using large ARMs, the above example may indeed be more real than they’d like. It is for illustration only, and intended only to show the directional spread between the Fixed and Variable rate structures. Be that as it may, the opportunity cost at 10% inflation on an ARM is 4.75% more relative to a fixed rate mortgage! Depending on the ARM’s particulars, this might lull an investor into staying with the ARM, since the ARM holder could conceivably be “getting paid” 1.75% to hold the ARM during a period of high inflation (-1.75% real rate). However, wouldn’t the investor rather be “getting paid” 6.5% (-6.5% real rate) by holding a fixed mortgage? By getting paid, we really mean that the dollars used to pay back the bank are worth only 93.5 cents, but the bank accepts them as full dollars. And of course we haven’t even discussed the increased cash flow requirements of the ARM just to service the mortgage. Adjusted for risk, go the way of the fixed mortgage!
Fixed Income CommentaryCorporate bonds, both investment grade and high yield, look relatively attractive. In fact over the last two months investment grade paper had a positive after-tax spread relative to Treasuries, and high yield paper had a positive tax-equivalent yield over municipal debt.
Treasury securities with longer maturities should be avoided, though Treasury Inflation Protection Securities (TIPS) could offer some additional protection in case of inflation.
CA Municipal Bonds have been all over the place over the last several months as CA has failed to come up with an acceptable budget, and has been issuing IOU’s for the last month. CA has been downgraded a couple of times, and now has one of the lowest credit ratings of any state in the US. Yields are fairly attractive in the 5.1% range, though CA is one or two credit downgrades away from “junk” status; if CA goes to “junk” (i.e. below “investment grade”), many mutual funds, Foundations, etc. cannot hold them due to investment policy guideline restrictions. If such a deterioration continues, we would look to this as perhaps a great opportunity, particularly if yields on CA municipals were to approach or exceed 5.5% double-tax free. Why? The reality is that what makes it into the news is mostly scare tactics that our schools, fire departments, police departments, and services will all be cut substantially. And yet, of the $24 Billion shortfall, $16 Billion of it will literally “go away” if a freeze is instituted on the automatic budgetary increases from 2008 to 2009. The remaining $8 Billion could be worked out by furloughing any type of union employees or state workers. In a terrible economic landscape it sure seems fair to say “you are going to keep your job, but at 90% pay” until things improve; most employees could make that adjustment if they had to do so. However, these moves take political will, and this is in scarce supply. CA is not likely to default on its General Obligation bonds, and if it did, it would roil the entire country’s municipal bond market. Expect more IOU’s from the State of CA, followed by either a budget deal or more downgrades. The problems are big, but as a great politician once said: “the answers aren’t easy, but they are simple.”
Thank you for your continued business and amazing referrals
I know this has been a very unsettling experience for all of us as investors. Please know that I am here to answer your questions, to go over your portfolio positioning in the context of your retirement plans, and to provide a sense of perspective in this market. Investing is a long term endeavor. Though risks remain, patience will be rewarded.
Posts
No comments:
Post a Comment